Global Investment Strategy

GIS September 26 (The New Cliché)

The two most important factors for any asset class—at this stage—are long-term interest rates and US elections. To discuss the future of interest rates, let’s look briefly at Japan.

What happened in Japan last week was extraordinary and unprecedented. The Bank of Japan (BoJ) has committed to cap 10-Y government bond yields at 0% no matter what.

The BoJ has told the market that the government can issue as many bonds as it wants; the 10-Y rate will not rise above 0% because the BoJ will buy as much as necessary.

The BoJ has also told the market that it doesn’t care if this money-printing and bond-buying experiment leads to inflation rising above 2%.

Most commentators don’t seem to fully understand the significance of this plan. This is called "helicopter money." Although long discussed in theory, it is new in practice.

In terms of spending power, Shinzo Abe—Japan’s current Prime Minister—is now the richest in the world. He can spend and invest as much as he dares.

Abe has much more leeway to raise government spending than Barack Obama does because Abe has more influence on legislative & executive bodies.

The BoJ and the Japanese government have effectively agreed to print money to spend and invest. Milton Friedman must be turning in his grave.

Europeans are carefully observing Japan because Eurozone seems to be following in Japan’s footsteps. Europe’s demography looks like that of Japan, with a 15-year delay.

Although Japan is at full employment (unemployment rate at 3%), it still has entrenched deflationary expectations. Europe is headed in the same direction.

Japanese banks’ margins are among the lowest in the world. Again, many European banks are headed in the same direction.

Japanese insurance firms needed help and the latest BoJ move helps them to a certain extent. Many European insurance firms will soon need help as well.

All this is to say that the similarities between Japan and Eurozone are striking. Ageing populations, excessive savings and disinflationary/deflationary expectations.

Whatever the long-term consequence of BoJ’s aggressive policy, in the short run, this money-printing and government spending will prove to be a boost to Japan’s equities.

Japanese equities will almost certainly outperform Japanese government bonds (JGB). There is little reason to be in JGBs instead of Japanese equities.

If the Fed—together with the White House—tried something similar, Congress would most likely shut it down in no time. The US President doesn't control the legislative body.

If Britain and/or Canada were to attempt something similar, they would most likely succeed because their political systems are similar to that of Japan.

More government spending/investment can only be effective if the money isn’t stolen. The so called "fiscal multipliers" are much lower if government spending is wasted on bribes.

Countries such as China, Brazil, India, Russia, Saudi Arabia or Malaysia—to name a few—could not follow Japan's lead because most of their government institutions are corrupt.

In the last edition of the widely-respected Journal of Finance, Dr. Patrick Bolton—the President of the American Finance Association—argues, in a fascinating article, that when it comes to financial management, we can think about nations/countries as corporations.

By drawing an analogy between corporate finance and sovereign finance, he explains that countries with low inflation can print money to build infrastructure, much like corporations can buy back their undervalued stocks. This is exactly what Japan is about to do.

Although we can easily observe a corporation’s Debt-to-Equity ratios, it is hard to define a sovereign country’s assets or equity. To manage countries like corporations requires a deep understanding of finance and economics. Very few people have both.

Given the powerful G-20 statement issued three weeks ago (see our previous Brief Note), governments that have more freedom to act (UK, Canada, Japan….) will increase spending faster than those that have to get legislative approvals (e.g. the US).

As argued in our previous publications (click to see), the probability of Donald Trump becoming president is 50%. This is because, when probabilities are too volatile, they become stochastic (probability of a probability) and hence converge towards 50%.

We discussed various asset allocation implications (regional, currency and asset class) of a Donald Trump presidency in previous GIS publications